Commentary on Markets and Political Economy

Real Fed Funds Rate: Long-term Chart & Analysis

Here, I present and analyze a chart of the ‘real’ fed funds rate since 1915. [Meaning, the fed funds rate minus the year-on-year change in the consumer price index.]

Click to enlarge. Source: St Louis Fed

I find it difficult to convey and articulate the importance of monetary analysis in the endeavor of contrarian investing; so I’m always looking for analogies. One of my favorites is this: imagine you’re a fisherman, and one morning you set off in your boat for your usual duties. Upon arriving at the place where you fish, you find that all the fish in the sea are dead. Do you seek an explanation by inspecting each and every fish? Or do you seek an explanation by examining the water in the sea?

The sea is to fish as money is to profit-seeking individuals.

When the real fed funds rate has been consistently positive, money has tended to be sucked into the banking system, and banks have been able to expand aggressively. During periods where the real fed funds rate has been consistently negative (or at least not consistently positive), money has tended to be withdrawn from the banking system, and banks have had to contract (sometimes aggressively). During the former periods, the money supply has tended to rise, whereas during the latter periods, the money supply has had tended to shrink.

What this means for business conditions:

Virtually all businessmen engage in this rudimentary activity: they swap money for things, and later swap things for money. Their aim is to realize a money profit. The above chart demonstrates periods of time when they have been helped and thwarted in this endeavor. During up-trends in the money supply, businesses swap money for things when money is relatively scarce, and swap things for money when money is relatively abundant. In other words, they – automatically – sell money high and buy it low (or buy things low and sell them high). Conversely, during down-trends in the money supply, businesses swap money for things when money is relatively abundant, and swap things for money when money is relatively scarce. In other words, they – automatically – sell money low and buy it high (or buy things high and sell them low). Clearly – if you’re a businessman – the former situation is favorable and the latter situation is unfavorable.

What the ‘Real’ Fed Funds Rate is showing today:

Arguably, we have been in a period of relatively poor business conditions since around 2001/2. Perhaps since 2007/8? Regardless, we can clearly see that we have entered a period where the real fed funds rate is not consistently positive. The corollary is – at least – that money supply dynamics are not favorable for business conditions. Furthermore, with central bankers evidently scared of a ‘systemic collapse’, it is likely that the real fed funds rate will remain negative (or not consistently positive) for years or decades to come.

Profit-seeking individuals may be slow to adapt to this environment:

Looking at the chart, it has occurred to me that profit-seeking individuals may be slow to react to this long-term shift in business conditions. Why? If we assume that the majority of businessmen are in the age-range of 25-55, then they were born somewhere in-between 1956 and 1986. Thus, the oldest of them have been ‘in business’ from around 1980 onwards. As can be seen on the chart above, Paul Volcker aggressively hiked rates around that time. The implication may be that the majority of businessmen’s ‘universes of experience’ have been during a period of money supply growth. As was shown above, these periods are generally favorable for business conditions. My take on this is that the process of adaptation could be rather painful.